Succession & Estate Planning Opportunities: Creating a Company Legacy

Succession & Estate Planning Opportunities: Creating a Company Legacy Presented by: Patricia Quintana-Perron, CPA, CHBC, CFP, PFS Cara Benningfield, CPA May 12, 2011 To Receive CPE Credit Participate in the entire webinar Answer polls when they are provided If you are viewing this webinar in a group Complete the group attendance form with Title & date of live webinar Your company name Your printed name, signature & email address All group attendance sheets must be submitted to L&D@bkd.com within 24 hours of live webinar Answer polls when they are provided If all eligibility requirements are met, participants will be emailed CPE certificates within 15 business days of live webinar Today s Agenda History on estate & gift tax Overview & planning opportunities Grantor Retained Annuity Trust (GRAT) What is an ESOP? Overview of different types of ESOPs Overview of different types of ESOPs Benefits & timeline for ESOPs Example: Sale to IDGT before ESOP transaction 1

History on Estate & Gift Tax 1916 - The Revenue Act of 1916 Introduced Modern Day Income Tax Revenue source 1% for estates of $50,000 (over $11.0 mil in today dollars) up to 10% on estates over $5.0 million (over $1.0 billion in today dollars) 1924 - Introduction of Gift Tax Levy on the transfer of property from one person to another Estate taxes continued to increase with rates up to 77% on the largest estates 1976 - Overhaul of Estate Tax System Created Unified Estate and Gift Tax Credit 1981 - Tax Bill Top rates went from 70% to 50% Established $600,000 unified credit History on Estate & Gift Tax 1997 - First increase in unified credit since 1987 With gradual increases beginning in 1999 slated to raise credit to $1.0 mil by 2006 2001 - Economic Growth &Tax Relief Reconciliation Act of 2001 First step to eliminating the estate tax Scheduled phase out of tax rates and increases in the unified credit 2010 - Repeal of the Estate Tax 2011 - Sunset of repeal & reversion to 1997 law with 55% top rate and $1.0 mil unified credit What Is the Estate Tax Today? December 17, 2010 - Tax Relief, Unemployment Insurance Authorization & Job Creation Act of 2010 Beginning 1/1/2010, estate, gift & generation skipping tax exemption is $5.0 million per taxpayer & the tax rate is 35% beginning in 2010 Beginning 1/1/2011, allowing portability of unused lifetime exemption from the last deceased spouse Lifetime gift exemption increases from $1.0 million to $5.0 million unifying the gift and estate tax exemption 2

2010 Decedents For decedent s dying in 2010, executors have a choice Default rule of estate tax regime of 35% rate & $5.0 million exemption or Opt out of the estate tax regime in favor of modified carryover basis regime How Does It Work? What is included in a taxable estate? All assets & debts Life insurance Fair market value of business interests IRAs 401(k)s Intangible assets Taxpayers with estates in excess of $5.0 million are subject to estate tax of 35% How Does It Work? Gift tax - lifetime Taxpayers can generally give a completed present interest gift of Up to $13,000 to any donee without gift tax imposition Amounts in excess of $13,000 reduce $5.0 million exemption Amounts in excess of the above are subject to gift tax of 35% on fair market value of the gift 3

How Does It Work? Generation skipping transfer tax Transfers (during life and/or death) to skip persons - subject to additional tax of 35% Skip persons = person at least two generations below that of the transferor Polling Question Based on today's legislation, what is the 2013 Estate, Gift and GST Tax Exemption per taxpayer? 1. $600,000 2. $900,000 3. 50% 4. $1,000,000 5. 35% Planning Opportunities Rates & Exemptions are Temporary Apply to 2011 & 2012 only 2013 - Gift, Estate and Generation Skipping Transfer (GST) tax revert to previously scheduled amounts $1.0 million exemption amounts (GST indexed for Inflation) 50% and 55% estate and GST tax 2 year GRATs (Grantor Retained Annuity Trusts) are still permitted Discounts to leverage value 4

Grantor Retained Annuity Trust Effective means for a wealthy client to retain income from a high yielding & rapidly appreciating property while transferring the property to a child with minimal gift tax or estate tax A GRAT is created by transferring one or more high- yield assets into an irrevocable trust & retaining the right to an annuity interest for fixed term of years or life At the end of the annuity term, assets in trust including their appreciation, go to named reminder beneficiary Grantor Retained Annuity Trust The most popular form of a GRAT is the short term trust with a remainder interest valued at near zero Advantage of shifting appreciation & income for a short period of time The administration proposed changes to GRATs requiring a minimum 10 year term which was not included in the Tax Relief Act of 2010 Act quickly - administration not likely to quit promoting these restrictions Sale to Defective Trusts Like a GRAT, it is an effective way to transfer part of a future income or appreciation from a high-income or rapidly appreciating asset with little gift cost Trust is created where the grantor is considered the owner for federal income tax purposes, requiring the grantor to report the income from this trust on his or her federal income tax return Grantor then initiates an installment sale of an appreciating asset to the grantor trust which generally does not result in a taxable transaction since the trust is ignored for federal tax purposes as a grantor trust Grantor then receives payment on the installment note from the trust using the cash flow generated by the asset itself 5

Sale to Defective Trusts Good alternative to GRAT for shifting future appreciation in the value of an asset for little gift tax cost When compared to GRAT, primary disadvantage is GRAT can be funded with virtually no taxable gift. Sale to Defective trust often requires an initial gift practitioners generally believe this to be at least 10% of the value of the asset being sold to the trust. This technique is likely to become more popular with the increased gift tax exclusion Polling Question What is the best type of asset to utilize with a GRAT or Sale to Defective Trust Strategy? 1. Low yield asset 2. Tax exempt bonds 3. Rapidly appreciating asset 4. Unimproved land with no intention to sell in short term Why Select An ESOP? Privately-held companies, by their nature, have less perpetuity than their public counterparts Founder/CEO energies & shifts in personal desires Wealth concentration; desire to diversify Competitive landscape & cost of growth Ultimately, the business owner is confronted with many important decisions, including How do I transfer leadership within my company? How do I monetize the value I ve created in my business? What constituencies are important as I start my life transition? Family Employees Community Customers Vendors 6

What Is an ESOP? Employee Stock Ownership Plan Qualified, defined contribution plan Invests primarily in sponsor company stock Company stock is held on behalf of employees/participants in ESOP trust ESOP trust is legal shareholder (not individual participants) p Participants have limited voting rights Two types Leveraged Non-leveraged Governed by IRC & ERISA, with oversight by IRS & DOL What Is a Leveraged ESOP? ESOP borrows money to acquire company stock (very similar to traditional leveraged or management buyout, plus significant tax advantages) Outside loan (company to bank/seller) Inside loan (ESOP to company) Used most commonly as part of succession plan to create stockholder liquidity & company legacy Can be used to acquire portion or 100% of company s outstanding stock Outside Loan Financing Alternatives Traditional bank financing Bank considers collateral, cash flow & strength of management Will have more cash flow under ESOP scenario Seller financing Subordinated to bank financing Typically increases company flexibility Mezzanine financing Combination of two or three of above 7

Why Do Companies Form Leveraged ESOPs? Create legacy company & preserve culture Provide vehicle to create stockholder liquidity (generally over time i.e., seller notes) Remain involved & in control of company (regardless of ESOP ownership amount) while developing next generation executive management team Reward long-term employees Develop compensation structure to properly motivate & retain executive management team Use tax enhancements (100% ESOP S corporation) to increase long-term growth ESOP Myths ESOP cannot pay fair value Owner(s) & management lose control There are no longer any significant tax benefits associated with ESOPs Everyone receives equal ownership, including executives ESOPs are too complicated Polling Question Have you previously heard any of these ESOP myths? 1. Yes 2. No 8

ESOP Myths Debunked ESOP can pay fair value Tax benefits of ESOPs are more significant than ever Owner(s) & management do not lose control Everyone receives allocations within the ESOP based on compensation, but it is also important to adequately compensate executives Just like any sale transaction, initial transaction is involved & complex, but having knowledgeable & experienced advisors can help facilitate successful & worthwhile transaction. Ongoing administration is similar to other retirement plans, with primary exception of annual company valuation How Much Can an ESOP Pay? Cannot pay more than fair value Generally determined by prospects for future cash flow (discounted cash flow) & market conditions Independent institutional ESOP trustee engages independent appraiser to assist in determining ESOP does not pay more than fair value Overall transaction is fair from a financial point of view, including Executive compensation structure Financing structure Negotiation process between seller & ESOP trustee Tax Benefits S corporation ESOPs 100% ESOP completely free of federal & generally state income taxes Less than 100% ESOP, partially free of federal & state income taxes Potential for significant first year tax savings/refunds C corporation ESOPs Deduct principal on ESOP loan Selling stockholders Stock sale Installment sale (with seller financing) Possible deferral or elimination of income tax on sale under IRC 1042 Will become more beneficial in environment of rising tax rates) 9

How Do I Sell My Stock Tax Free? Covered under IRC Section 1042 Not heavily used in today s environment, but in future years may become more advantageous Requirements include Generally must have held stock for at least three years Must be C corporation on date of sale under current tax law ESOP must own 30% or more of company after sale Must reinvest in qualified replacement property (QRP) within 12 months from date of sale How QRP Works Essentially stocks or bonds of domestic operating companies (mutual funds, municipal bonds, etc. do NOT count) Sale of QRP during lifetime triggers income tax If hold QRP until death, receive step-up in basis of QRP & income tax vanishes Benefit to Employees Eligible employees i.e., generally 21 years of age & one year of service can participate Shares released annually based on repayment of inside loan For example, approximately 1/15 of total shares allocated annually assuming 15-year loan with equal payments Shares allocated based on compensation (subject to IRS limits) Participants receive annual statements reflecting number of shares of stock allocated to their account & stock value Either six-year graded or three-year cliff vesting from date ESOP is formed Except for death, disability or normal retirement, terminated vested participants receive cash for value of stock once ESOP loan is repaid 10

Polling Question Do you currently have an ownership & management succession plan in place? 1. Yes 2. No Executive Compensation Important to design incentives that align interests of executives with those of ESOP Bonus structure Synthetic equity Trustee approval Reasonable compensation Not too dilutive to ESOP Overall fairness 100% ESOP-Owned S Corporation Tax Advantage in Acquisitions Subsidiary 1 Tax-Free Gain Treatment for Sellers Subsidiary 2 ABC Company, Inc. ABC Company, Inc. Employee Stock Ownership Trust (100% Owner) Advantages Tax Exempt No Federal or State Income Tax 40% to 46% More Cash Flow than Competitors 11

Transaction Advisors BKD Financial advisor & quarterback Corporate counsel Independent ESOP trustee Negotiates transaction terms, including purchase price & stock purchase agreement Counsel to ESOP trustee Financial advisor to ESOP trustee Valuation & fairness opinion Bank & bank counsel Typical Transaction Timeline Initial discussions Day 1 Decision to move forward with ESOP structure recommendations study Day 30 ESOP structure recommendations study completed & presented to company Day 31 Begin preparation of formal forecast & business plan, if necessary ESOP trustee ss financial advisor begins appraisal process Day 40 Presentations to prospective lenders Day 55 Select lender(s) Day 56 ESOP trustee & its advisors begin due diligence process Transaction documents begin to be drafted Day 85 Final terms, including purchase price, negotiated & agreed to Day 90 Close transaction Essentials for ESOP Candidate? Owner looking to create legacy company & willing to carry some of financial risk, i.e., seller notes for period of time Strong management with commitment to employee ownership Company has equity value of $5 million or greater Pays significant amount of income tax Stable cash flow Sufficient employee/payroll base, i.e., generally 50 or more employees 12

Example: Sale to IDGT prior to ESOP Dad owns 100% of SCorp valued at $5,000,000 Dad wants son to own 30% interest in SCorp in a trust that would benefit son & son s children FMV - Minority interest in SCorp Shares Estimated discount for lack of marketability & minority interest of 25% Fair market value of 30% interest - $1,125,000 ($1,500,000 undiscounted) Dad does not want to use $1,125,000 of unified credit to gift the entire interest to son Dad subsequently enters into an ESOP transaction Example: Sale to IDGT prior to ESOP Step 1 Create IDGT for benefit of Gen 2 Retain power (ie, power to substitute assets) Treated as grantor trust for federal income tax purposes Fund trust with seed money (ie, $112,500) (report on Form 709) Gen 1 Owns SCorp 10% Cash Gift ($112,500) IDGT Example: Sale to IDGT prior to ESOP Step 2 Gen 1 Sells % of SCorp to IDGT in exchange for a 10% down payment in cash & a 9 yr note receivable (midterm rate 2.44%) Note must be for AFR at minimum Gen 1 30% SCorp Stock Gen 1 --$112,500 - Note Receivable -($1,012,500) 10% Cash Down payment Note to Gen 1 ($1,012,500) IDGT - 30% SCorp Stock IDGT -30% SCorp Stock 13

Example: Sale to IDGT prior to ESOP Step 3 IDGT Sells 30% interest in SCorp stock in ESOP transaction for $1,500,000 (30% of $5,000,000) & receives cash on sale IDGT can make interest only payments on note ($24,705/yr) Invest excess cash in order to leverage earnings - assume earnings of 6%. Retains excess cash on sale and any growth in subsequent asset Gen 1 Reports K-1 on 1040 K-1 Profit/Loss SCorp Gen 1 Receives Note Payments Note Payments IDGT Retains Excess Cash And Growth in SCorp SCorp Example: Sale to IDGT prior to ESOP After 9 years, Assuming 6% rate of return on the investments inside the IDGT less annual interest payments on note, the IDGT has $2,233,292 available The IDGT pays the outstanding principal balance on loan of $1,012,500 The IDGT still retains $1,220,792 of assets available for son and grandchildren with Dad only having to use $112,500 of unified credit. This growth will not be in Dad s estate with approximate estate tax savings of $387,902 (assuming 35% rate) plus GST benefits Additionally, Dad has been paying taxes on the income earned inside the IDGT. Assuming a 25% tax rate, Dad paid $238,909 in income taxes without having to report a gift or use any additional unified credit - this also reduced Dad s estate & saved $83,618 in estate tax (assuming 35% rate) QUESTIONS? 14

Thank You Patricia Quintana-Perron, CPA 10001 Reunion Place, Suite 400 San Antonio, TX 78216 210.341.9400 pperron@bkd.com Cara Benningfield, CPA 400 E. Main Street, Suite 200 Bowling Green, KY 42102 270.781.0111 cbenningfield@bkd.com Continuing Professional Education (CPE) Credits BKD, LLP is registered with the National Association of State Boards of Accountancy (NASBA), as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be addressed to the National Registry of CPE Sponsors, 150 Fourth Avenue North, Suite 700, Nashville, TN, 37219-2417. Web site: www.nasba.org CPE Credit CPE credit will be awarded upon verification of participant attendance; however, credits may vary depending on state guidelines For questions, complaints or comments regarding CPE credit, please email the BKD Learning & Development Department at L&D@bkd.com. 15